Back to Basics…What is Risk?

Back to Basics…What is Risk?

We talk a lot about risk in the financial industry: financial risk management, the role of risk-based capital, measuring profitability based on risk characteristics and the need for risk-based loan pricing, etc.

But what does it really mean?

Let’s go back to basics though and look at what is risk? Merriam-Webster defines it as such:

1possibility of loss or injury
2someone or something that creates or suggests a hazard
3the chance of loss or the perils to the subject matter of an insurance contract; alsothe degree of probability of such loss
4the chance that an investment (such as a stock or commodity) will lose value

Essentially, “risk” means unpredictable variability. Reliable predictions of an outcome tend to reduce the risk associated with that outcome. Similarly, low levels of variability also tend to reduce risk. People who are “set in their ways” tend to lead less risky lives than the more adventuresome types. Insurance companies love the former and charge additional premiums to the latter. This is a terrific example of risk-based pricing.

Financial services involve risk. Banks have many of the same operational risks as other non-financial businesses. They additionally have a lot of credit risk associated with lending money to individuals and businesses. Further, banks are highly leveraged, borrowing funds from depositors and other sources to support their lending activities. Because banks are both collecting interest income and incurring interest expense, they are subject to market risk (or interest rate risk.)

Banks create credit policies and processes to help them manage credit risk. They try to limit the level of risk and predict how much they are incurring so they can reserve some funds to offset losses. To the extent that banks don’t do this well, they are acting like insurance companies without good actuarial support. It results in a practice called “adverse selection” – incorrectly pricing risk and gathering many of the worst (riskiest) customers.

Sufficiently good credit risk management practices control and predict most of the bad outcomes most of the time, at least at portfolio levels. Bad outcomes (losses) that are not well-predicted, and therefore mitigated with sufficient loan-loss reserves, will negatively impact the bank’s earnings and capital position. If the losses are large enough, they can wipe out capital and result in the bank’s failure. This is why it’s essential to implement a risk management solution.

The word “risk” may have a simple definition, but in practice it can be complicated to address – especially in the financial industry. Going back at the basics is a great place to get started.

Topics: risk management